Monday, November 16, 2009

The Credit Card "Business"

By Mike Dorf

As various commentators have noted, the traditional business model of credit card companies is peculiar. Here is how James Surowiecki described it in a May issue of the New Yorker:

Their best customers aren’t those who dutifully pay off their balance every month; instead, they’re the ones who charge a lot and pay only a little every month, carrying a sizable balance and racking up interest charges and late fees. These are the “revolvers,” and the credit-card business feeds on them. Credit-card companies don’t necessarily want revolvers to pay off their debts; if they did, there’d be no interest or fees to collect.
. . . The catch is that while revolvers are the companies’ best customers, they’re also more likely to default, which would make them the worst.

Accordingly, Suroewiecki and others have noted, with increasing default rates, the credit card companies have been re-thinking their business, trying to find ways to shed default risks and to make money from their regularly paying customers, or what I shall call "free riders."

Right now, I am a free rider. I pay my balance in full on time every month, and thus I get the benefit of the float on my purchases along with the convenience of not having to carry too much cash. For this I pay essentially nothing. I could pay literally nothing but I use a card with a small non-zero annual fee because it enables a small percentage of my charges to go to a favorite charity; however, I doubt that the annual fee covers the credit card company's administrative costs, even when one takes account of the fees charged to merchants.

So, how could the credit card companies make money from people like me, i.e., good credit risks? They could start charging merchants a lot more for credit card use, although the downside here would be reduced demand. At some point, merchants would have to charge higher prices for credit than for cash (as some already do, and not just as a way of defrauding the government of sales tax), and that would in turn lead to less credit card usage by customers.

Another approach would be for credit card companies to start operating more like conventional banks, by charging all customers interest on their loans. In this model, if I make a purchase on Nov 1 and pay the bill on Dec 1, I would pay a month's worth of interest on the purchase. The disadvantage here is that it too will reduce demand for credit cards, as consumers like myself--who use credit cards as a convenience rather than as a means of borrowing money--would switch to cash and debit cards. Raising fees for all credit card users is another option with the same tradeoffs, although consumers could be left without real alternatives if banks start charging or raising fees for cash withdrawals and debit card use.

Various news stories suggest that the credit card companies have been experimenting with each of the above tactics but if my personal experience is a guide, they are also trying something else: They are trying to turn free riders like me into revolvers. Thus I doubt that I am unusual in getting cash-advance "checks" from my credit card company roughly once a week. And recently, I experienced what looks to be a more aggressive effort. I received a notice in the mail that my credit card had been compromised by a third party, though no fraudulent charges had been made. As a precaution, the company sent me a new card. To activate it, I called the number on the card and when I keyed in my account number, instead of getting an automated menu, I was re-routed to a "customer satisfaction expert." Here's a rough transcript of our ensuing conversation, after the preliminaries identifying my account and myself.

CSE: How may I help you today?

ME: I'd like to activate my card.

CSE: I can do that for you. It will only take a few minutes. [Sounding somewhere between disappointed and annoyed:] I see here that you pay off your balance in full every month.

ME: Aha.

CSE: While we're waiting, I'd like to tell you about our exciting 0% balance transfer and checking account deposit. What do you think you'd like to use yours for?

ME: I'm not interested, thank you.

CSE: You're not interested in saving money? That's especially surprising in this economy.

ME: Sorry.

CSE: Okay, your card is activated. Can I help you with anything else?

ME: No thank you.

CSE: Thanks for calling [credit card company]. Have a great day.

I don't know whether I was inadvertently kicked over to the CSE in the first place, but it wouldn't surprise me if this were a deliberate program to flag free riders and attempt to turn them into revolvers. If so, this seems like a bad idea. We free riders are free riders precisely because we understand the hazards of profligate use of credit cards, teaser rates, and so forth. It's not that we oppose credit. Most of us have mortgages. Many have car loans, etc. It's just that we realize that the whole credit card business is built upon getting people in over their heads on high-interest loans. So I doubt very much that the sales pitch will work on other long-time free riders.

Now I certainly could be wrong about that. After all, I'm not an expert in the credit card business or even in finance more broadly. But still, it's not as though the people in this business have been doing a very good job lately--unless you define the business as "getting bailout money from the government." So if I am right that the plan to turn free riders into revolvers will largely fail, and if the credit card companies continue to worry that people who used to be reliable revolvers will, for the foreseeable future, continue to pose too high a risk of default, then we are likely to see the companies make greater use of the fees and interest strategies, even with the resulting decreased overall use of credit cards.

It's tempting to view such a movement as economically harmful in the short run: Credit card use generally leads to increased consumer spending, which is needed for a robust economic recovery. But in the long run, it's hard to argue that our economy should be dependent on people taking on high-interest debt beyond their means to pay.

31 comments:

This is a wonderfully instructive anecdote, Mike, and your reflections thereon are characteristically just as edifying if not indeed moreso -- many thanks! One quick complementary anecdote that many 'out there in the world' might not know is this: While we tend to think of the paradigmatic 'subprime' mortgage debtor as someone who would not otherwise have qualified for mortgage credit at all, this is not the case. A substantial percentage were in fact 'converts' from prime mortgages. They were, in other words, people more like you who were successfully converted to the mortgage analogue of credit card 'revolvers.' The aim of getting prime mortgage debtors to 'refi' into subprime mortgages lay at the core of the business model of subprime mortgage orginators, as well as those of subprime mortgage bundlers and mortgage-backed security sellers. And the reason for this is much the same as that which you intimate here: These firms profit only when they succeed in luring large numbers of people into debt peonage, just as London bankers did in the 18th century with colonial Virginian and North Carolinian planters, and just as many NY and Philadelphia banking interests did with midwestern farmers in the late 19th and early 20th centuries. Plus ca change!

I'm pretty sure the "credit card companies" (Visa, Mastercard, etc.) don't own the card balances; they mostly make money via card transactions at retailers and other outlets. Banks on the other hand, manage balances and other account fees.

This means that companies like Visa make money no matter how much you "free ride" your account.

Just throwing that out there to highlight the fact that interests in the business aren't all perfectly aligned.

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I’m against using credit cards cause you don’t know where you spent your money. I [refer paying cash or taking loans and paying cash. I often turn to trusted pay day lenders. If it is interesting you can try this out. It’s simple and fast way of taking loans that is why I use it. And I always know how much money I should pay back and when I have to do this.

Credit cards can be useful but they can also be dangerous. You can build up large balances that get out of hand. Another option is short term or payday loans. This option means you can borrow the money and then pay it back in one go. This method is better for a lot of people so you can try this out.